EDHEC Advanced Corporate Finance

Valuation Manual
January 2018
Valuation Manual

This manual has been prepared to provide students of the EDHEC Advanced Corporate
Finance module with an overview of standard valuation techniques and discussion of key
issues. It should not be relied upon in a professional setting and should not be distributed
without consent.
Valuation Manual

Contents
1. Summary of valuation methodology 4
1.1 Summary of valuation methodology 4
2. Forecasting a business plan 5
2.1 Introduction 5
2.2 Check notes to accounts & read MD&A 5
2.3 Key operating data 5
2.4 Key financing data 8
2.5 Other profit & loss items 8
2.6 Other balance sheet items 9
2.7 Net debt 9
3. DCF analysis 10
3.1 Introduction 10
3.2 Why do we use DCF? 10
3.3 Which cash flows do we value? 10
3.4 Explicit cash flow forecasts and the terminal value 12
3.5 The valuation exercise 12
3.6 Terminal Value 13
3.7 Discounting free cash flows and continuing value 15
3.8 From present value of FCF to equity value 16
3.9 Sensitivity analyses 19
4. Weighted Average Cost of Capital 20
4.1 Cost of Capital 20
4.2 The cost of equity 20
4.3 The cost of debt 2
4.4 The effect of tax on the cost of debt and equity returns 4
4.5 Capital structure and weightings 4
5. Multiple valuation 5
5.1 Introduction 5
5.2 Enterprise value vs market capitalisation 5
5.3 Accounting for subsidiaries, associates and investments 5
5.4 Treatment of minority interests and income from associates in multiples 6
5.5 General procedural rules 7
5.6 Accounting inputs 7
5.7 Control premiums 7
5.8 Comparable transactions 7
Valuation Manual

5.9 Rolling multiples 8

5.10 Other factors to consider 8
6. LBO analysis 9
6.1 Introduction 9
6.2 An LBO model 9
6.3 Types of financing 10
6.4 Entry and exit multiples 14
6.5 Returns to capital providers 14
6.6 Check list for an LBO analysis 15
Appendices 17
I. Modelling tips & tricks 18
Valuation Manual
1. Summary of valuation methodology
1.1 Summary of valuation methodology
A company valuation should always be based on a combination of techniques; the key techniques often used are
set out below, with associated ‘pros’ and ‘cons’ for each method:
Overview
DCF analysis • Fundamental analysis of future
profit, cash flow, growth and risk
profile
• Standalone valuation is absolute •
rather than relative to current
valuations
• Validity of assumptions used
determine to which extent DCF
analysis can be used i.e.
‘garbage in – garbage out’
Comparable • Analysis based on market value
Companies (“CoCo”) of comparable companies
also known as
Trading multiples • Relative valuation rather than
absolute
• Equity market multiples applied
to forecasted normalised
operating results
Comparable • Analysis based on pricing of
Transactions comparable transactions
(“CoTrans”) also
known as • Relative rather than absolute
Transaction valuation
multiples • Applied to historical LTM
operating results
LBO analysis • Valuation driven by debt capacity •
and IRR target of sponsor
• Fundamental analysis of future
cash flows and standalone debt
capacity
Net asset value • Balance sheet based valuation
(NAV) approach
• Used primarily in asset heavy
industries and in particular real
estate
• Balance sheet items can be
individually ‘marked to market’
where possible
Pros Cons
• Identifies absolute value – no • Difficult to derive accurate
need for comparison with peer forecasts for sales, EBITDA,
group capex etc without management
assistance
All value drivers taken into
account • Sensitive to assumptions on
discount rate, long term growth
and terminal value
• Simple widely-used valuation tool • Static-priced
• Useful for comparisons of relative • Difficult to value unprofitable
value businesses
• All value drivers incorporated into • Takes no account of long-term
one statistic value drivers – growth, margin
improvement etc.
• Most suitable for mature
companies • Historic multiples take no
account of future fortunes
• Market inefficiencies (e.g. small
cap. effect)
• Simple widely-used valuation tool • Difficult to value unprofitable
businesses
• All value drivers incorporated into
one statistic • Difficult to split out level of
synergistic benefits
• Includes premium for control
(‘takeout’ valuation) • Private vs public company
control premium
• Quality of data
Estimates the price level a • Difficult to forecast out accurately
financial buyer is prepared to pay
on basis of IRR requirements • Exit value/multiple is critical
• Efficient/aggressive capital • More focussed on price rather
structure than fundamental value
• Based on same operating • Sponsor IRR becomes the key
assumptions as DCF driver
• Can be used to approximate • Ignores future profitability / cash
liquidation / break-up value flows
• Balance sheet items can be
historical and cost based
• Assets can only marked to
market where reliable valuation
benchmarks exist
Valuation Manual

2. Forecasting a business plan

2.1 Introduction
When conducting a company valuation it is important to understand its historical performance. By analysing a
company’s historical performance one should:
 Identify all key BS, P&L as well as CF line items
 Perform ratio analyses and identify the key trends of these ratios
 Benchmark historical ratios with comparable companies or sector averages
Furthermore, it is equally important to understand the business, industry dynamics and firms’ strategy. The
following steps should be taken into account:
 Acquire basic understanding of the business
 Conduct analysis on key industry trends
 Develop a view on the companies’
- competitive environment
- opportunities & threats
- strengths & weaknesses
- strategy going forward
 Identify the key value drivers of the industry and firm
 Construct a plausible storyline for forecasting
A business plan is an important tool for analysing a company's prospective financial performance/position. The
derivation of the assumptions underpinning a business plan provides a useful framework for bankers to discuss
the company's prospects/operating environment with company management. As well as highlighting a company's
principal value drivers, the business plan will form the foundation for among others a DCF analysis, an LBO
analysis and a merger analysis.

2.2 Check notes to accounts & read MD&A

An important part of analysing a company’s prospective financial performance/position concerns analysing the
historical financials of the company through a.o. annual reports. Always check the notes of a company’s annual
report and read the management discussion and analysis when analysing a company as these sections can
provide some of the most valuable insights into the company’s operations.

2.3 Key operating data

2.3.1 Revenue (or sales or turnover)

Net sales
In basic terms revenue is sales volume (Q) multiplied by price (P). In order to forecast sales one should try to work
on the basis of a P * Q analysis if applicable as this helps to understand the drivers of the business. To model
sales volumes you should consider the economic and industry environment of the product concerned (using
company forecasts, research reports – company as well as industry, trend figures and so on) and understand the
developments of market share (historically and going forward). When projecting prices it is best to differentiate
between real price increases and those due solely to inflation (as noted below, inflation rates should be a ‘global’
figure throughout the model affecting all the projections). The product 1 of the real price increase and inflation gives
the nominal price increase applicable to the relevant unit of production.

Work in progress

1
Technically the nominal price increase n is given by (1+n) =(1 +i) x (1+r), where i is the rate of the inflation and r is the real
price increase. However, at most projected growth rates and inflation levels there will not be a large error introduced by
simplifying this to n = i + r.
Valuation Manual

The source of work in progress related sales should be analysed and included in a separate line item in the model.
On the long term work in progress should trend towards zero as you may assume that on the long term production
volume is equal to sales volume.

Elimination of intercompany sales

Always carefully analyse any elimination of intercompany sales for a sales forecast based on separate business
entities. One should show this item as a separate correction. Intercompany sales should not affect the
consolidated financials, as these are eliminated in the consolidation process and therefore should have no impact.
However, basic understanding of intercompany sales enables to understand dependencies between different
entities within the company and avoids inconsistencies between the sales forecasting between those entities.

2.3.2 Cost of sales, operating costs, administrative expenses etc.

Cost of goods sold
The items included under each heading in the company’s accounts will depend on company’s accounting policies.
For example, many companies do not only include the direct costs of manufacturing an item (i.e. the raw
materials, energy etc.) in ‘cost of sales’, but also include an allocation of overheads such as head office costs and
factory depreciation. To the extent that costs are separately identifiable it is best practice to model them separately
according to the driver that relates to the cost rather than as a simple percentage of sales (for example if revenue
increases due to increases in price it may have no direct effect on manufacturing costs hence the gross margin will
expand). Therefore it is best to model direct costs based on the volume driver in the sales forecast plus a cost per
volume unit increase and forecast indirect costs based on the source of the cost concerned. The ‘accounting’ can
then be dealt with separately, obviously dependent on the information available. Cost of goods sold can be
modelled as a percentage of sales, but one should keep in mind the above and change the driver sheet
accordingly based on available information. Please bear in mind that in order to present figures which can be
recognised by the client, the definition as used in the company’s financial statements should always be used.

Operating costs
Operating costs comprise all costs with a fixed as well as a variable nature, including personnel expenses (wages
and salaries, social security charges, pension charges), selling and marketing expenses, IT expenses, R&D
expenses etc. To the extent that operating costs are separately identifiable it is best practice to model them
separately according to the driver of that cost rather than as a simple percentage of sales. This is especially the
case with personnel expenses. Information regarding FTEs is available for most companies. If possible, wages
and salaries forecasts should be based on number of FTEs multiplied by cost per FTE. As mentioned earlier,
using a P * Q approach is the preferred option as it reflects in a better way the effect of economies of scale. Other
personnel expenses such as social security and pension charges are usually forecast as a percentage of total
wages as this is the driver of these costs.
All other operating costs in can be modelled as a percentage of sales, and as such one should model costs on a
separate sheet if another driver is more applicable. With regard to R&D and IT costs one could choose to
forecasts these costs with a growth rate for the first years (for example 3 – 5 years) of the business plan and once
sales have ended up in steady state switch the driver as a percentage of sales.

Exceptional items
To be able to forecast the underlying business accurately, exceptional items such as restructuring charges should
be excluded from historical reported figures and modelled separately going forward. By definition exceptional
items should be non-recurring. However, based on e.g. expected restructuring costs in the business plan period
exceptional costs may occur in the near future. Always analyse whether these costs are actual cash outs and if so,
do take them into account in the free cash flow calculation of the valuation.

2.3.3 Depreciation
There are a number of ways to forecast depreciation of tangible fixed assets. A standard approach is to forecast
as a percentage of average tangible fixed assets. Effects of disposals/acquisitions and the timing thereof during
the year should be taken into account when analysing historical figures.
From a valuation/cash perspective please bear in mind depreciation has only an effect on taxes paid.
Depreciation could also be modelled using a useful economic life concept. In this more detailed approach existing
fixed assets and future capital expenditures are depreciated based on their respective useful life.
Valuation Manual

2.3.4 Amortisation
Amortisation involves depreciation of intangible assets such as intellectual property i.e. licences, rights to royalties,
brands, broadcasting rights etc. and goodwill. Please note that in most accounting regimes goodwill on
acquisitions is no longer amortised but impaired, if deemed necessary, based on reduced expected future
profitability of the assets to which the goodwill relates. Amortisation (not related to goodwill) is forecasted as a
percentage of average intangible fixed assets.

2.3.5 Capital expenditure

Broadly speaking, companies invest in fixed assets for two purposes: (i) maintaining existing operations
(maintenance capex), and (ii) facilitating growth of the business (expansion capex)
When making financial projections it is best to work towards a ‘steady state’ at the end of the forecast period as
this will drive the continuing value. In the steady state, maintenance capex should be in line with depreciation
(slightly higher than depreciation due to inflation) as maintenance capex will be needed to facilitate ongoing
business performance. Capital expenditure supporting business growth would rationally only be incurred when the
investment is perceived to have a positive NPV, and hence to model this you would need to take into account the
incremental effect on sales, costs etc.
In other words, when making assumptions on sales growth etc. these should be consistent with the expansion
capex assumptions – for example it would be incorrect to assume 20 percent real volume growth in sales without
any additional capex as production capacity (in case of a manufacturing company) of existing assets will have a
physical maximum.
If limited volume growth is assumed in the model (in a steady state, a company sales growth is expected to be in
line with industry growth), it is best to assume that the majority of capital expenditure is maintenance expenditure.
In this case the level of maintenance capital expenditure should be in line with the level of depreciation, as
depreciated assets must be maintained or replaced – and in the long run the level of maintenance expenditure
would be expected to be equal or slightly above the level of depreciation. In summary, the level of depreciation to
enter into a model can often be estimated by reference to the level of maintenance expenditure and vice versa,
whereby expansion capex should be in line with the real growth of the business.

2.3.6 Working Capital

Net working capital is the amount ‘invested’ in inventories (raw materials, work-in-progress and finished products),
as well as debtors for products or services sold, net of creditors for products or services received.
Generally as a business grows it consumes working capital (i.e. the amount invested grows and hence the
business requires more cash). Some businesses have negative working capital (for example Subscription Based
Media) due to the fact that cash is received from customers on Day 1 (start of subscription) whereas suppliers are
paid on “normal” credit terms e.g. 30 - 45 days later and inventory is low. In this case as the subscription based
media company grows, less, rather than more, cash is required as the business is in fact partly financed by its
subscribers. In forecasting cash flows it is essential that appropriate regard is paid to the working capital
characteristics of the business under review.
Note that an increase in net working capital is a usage of cash (consider it as buying an investment) – conversely
a decrease is a source of cash generation. Working capital days calculations can be used to forecast working
capital items from revenues and cost of sales forecasts. Inventories as well as trade payables are related to cost
of goods sold, while trade receivables are related to revenues.
Other working capital items, such as other current assets, other receivables, other payables and current tax
payables have been forecast as a percentage of revenues. In addition, operational cash, i.e. cash which is trapped
in the business as this is required to operate the day-to-day business is also considered a working capital item in
most models.

2.3.7 Provisions
Projecting provision movements starts with an analysis of the historic use of provisions in order to ascertain the
true cash flow impact on the business. However, it is possible that provisions made historically will represent
necessary cash expenditure occurring in the future. For example, some companies consistently have to make
provisions for ongoing bad debts or companies might estimate certain costs to restructure its business (closing
factories, redundancies etc.) and to avoid ongoing ‘damage’ to the profit and loss account it will provide for this in
a particular year.
Movements in provisions consist of i) non-cash additions which are included in EBITDA as a cost, ii) non-cash
releases which are also included in EBITDA as a one-off gain, and iii) the actual usage of the provision that has a
cash flow effect and therefore will flow through the cash flow statement. When analysing the cash flows of the
business, EBITDA has to be adjusted for the non-cash movements included in EBITDA.
Valuation Manual

Another and easier approach, which is applied in calculation of the cash flows in most standard models, includes
the net movement in the balance sheet position which incorporates the non-cash adjustment for EBITDA as well
as the cash uses. Furthermore, provisions can be split into operating and non-operating provisions for modelling.
Operating provisions are included in the DCF valuation via the free cash flow calculation and include a.o.
guarantees, recurring employee related provisions, restructuring provisions and deferred tax liabilities. Non-
operating provisions relate to a.o. pension provisions, which should be evaluated separately and treated as a debt
like item in the Equity Value calculation.

2.4 Key financing data

2.4.1 Interest
Interest income can be modelled as an interest percentage on the average cash position throughout the year. The
interest rate on cash should be based on deposit rate. Interest expenses are forecast by an interest percentage on
the average debt position throughout the year. The interest rate on borrowings at any point in time should be
based on the credit terms which often can be found in the notes of the annual report.

2.4.2 Dividends
Companies generally aim to pay a dividend per share which grows moderately each year, providing a stable and
increasing income to the shareholders. As a rule, they do not try to maximise payout in one year, only to have to
reduce the payout when profits are disappointing. Hence, dividend forecasts are based on the number of shares
outstanding multiplied by a dividend per share. The pay out could, alternatively, be calculated in relation to the
dividend cover (earnings/dividends). Fast growing companies will generally show a low dividend pay out ratio, as
these companies require the cash to finance business growth. Mature, less growing stable businesses will have in
general higher dividend payout ratio’s. In most continental European countries, only a final dividend is paid, unlike
for example UK public companies, where interim dividend as well as final dividend are more common (split is most
commonly 1/3:2/3).

2.4.3 Tax
Tax should be calculated in accordance with the requirements of the countries of operation of the business
concerned. Generally this will involve adjustments to the accounting profit by adding back cost items that the
taxation authority does not recognise, or deducting items which are not recognised in the accounting policies but
eligible for tax allowances. In a standard model taxes can be forecast by multiplying the statutory tax rate by
taxable income. Taxable income refers to Profit Before Taxes (PBT) adjusted for all non-tax deductible items such
as goodwill amortisation and tax credits not recognised in the PBT. Statutory tax rates for all major countries can
be found in an annually published KPMG Tax Survey report. When the company incurs taxation in different
countries, try to estimate the country average statutory tax rate based on a weighted average of the profits and
applicable statutory rates in the applicable countries in order to forecast taxes.

2.5 Other profit & loss items

2.5.1 Income from associates (after tax)

Income after tax resulting from non-controlling equity stakes, generally lower than 30%. Please check whether this
item is net of tax. Income from associates is an accounting item which is based on the profit after tax of the
involved associate multiplied by the equity stake. The retained profit of the associated company is not a cash item
and will increase the balance sheet position. Usually associates can be found as a separate line item in the
balance sheet or under financial fixed assets. Cash movements are the result of actual dividends received from
the associates which should be reflected in the cash flow statement. Do not forget to make a positive adjustment
for the value of the equity stake in the associate company as an adjustment to be included in the bridge from
Enterprise Value to Equity Value (see also paragraph 3.8).

2.5.2 Exceptional items (after tax)

Any non-recurring, non-operational income or expenses, such as the sale of property. Please check whether this
item is net of tax. If the effect of the exceptional is not reflected in the Free Cash Flow but has a cash effect, an
adjustment has to be made in the bridge from Enterprise Value to Equity Value.

2.5.3 Minority interest P&L

Minority interest relates to companies which are consolidated in the financial statements of the company but are
not 100% owned. The minority interest represents the share in after tax profit of the subsidiary that is attributable
to the other shareholder(s) of the minority company. Alike income from associates the retained profit is not a cash
Valuation Manual

item and will increase the balance sheet position. Cash movements are the result of actual dividends paid to the
minority shareholders that has to be reflected as a cash out in the cash flow statement. Do not forget to make a
negative adjustment for the value of the third party stake in the minority company as an adjustment to be included
in the bridge from Enterprise Value to Equity Value.

2.6 Other balance sheet items

2.6.1 Deferred tax assets (DTA)

An asset on a company's balance sheet that may be used to reduce any subsequent period's income tax expense.
Deferred tax assets can be split into assets as a result from differences between the commercial and fiscal
financial statements (e.g., due to differences between depreciation for tax versus commercial purposes) and from
net loss carry forwards. Tax assets are recorded on the balance sheet based on the expected use versus future
profits. In case a loss is recorded the balance sheet, the DTA position on the balance sheet increases
automatically by the pre-tax loss incurred in a particular year multiplied by the relevant tax rate. Do not forget to
make a positive adjustment for the value of the DTA at the valuation date as an adjustment to be included in the
bridge from Enterprise Value to Equity Value.

2.6.2 Debt
Debt can be forecast in detail, per debt component or on an aggregate level. In an LBO analysis detailed debt
forecasting is key, however in a DCF valuation aggregate forecasting is sufficient. In a standard DCF model
aggregate forecasting of debt can be applied, while a standard LBO model provides a detailed breakdown of all
debt items.

2.7 Net debt

Net debt is defined as all interest bearing debt minus cash and marketable securities. In determining the net debt
one should include off-balance sheet commitments that have a high probability of being materialised in the future
and be aware to exclude restricted or operational cash. One should check if hybrids are included, such as
preference shares, convertibles, perpetuals and shareholder loan notes. Please note a detailed bridge from
Enterprise to Equity Value and the various value adjustments will be discussed in Chapter 3 (paragraph 3.8).
Valuation Manual

3. DCF analysis

3.1 Introduction
The discounting cash flow (DCF) analysis is a valuation method to calculate the present value of the expected
future cash flows from the company or project (adjusted for risk and timing). The DCF method is, theoretically, the
best estimate for the fundamental value of a company or project. However, certain elements of the theory are
subject to debate, and in practice the value based on DCF heavily depends on underlying assumptions being used
for forecasting the cash flows and the discount rate. DCF’s should certainly never be treated as a black box, or as
truly being the ‘perfect’ value.

3.2 Why do we use DCF?

DCF is a key valuation tool as it enables us to estimate the value of a business or company either as a stand-
alone entity or to an acquirer; also the impact of any future developments (e.g. changes in the business itself or
synergy benefits brought by an acquirer) can be taken into account simply by reflecting these in the cash flows. It
is a rigorous method forcing us to make explicit assumptions which can be tested, rather than the implicit
assumptions which underlie the use of multiples. Using the data generated by a DCF model we can perform
sensitivity analyses, for example to test the effect of different scenarios. Similarly, we can ‘invert’ the model to see
how a business has to perform in order to justify a particular value.

3.3 Which cash flows do we value?

The figure below describes the standard DCF valuation framework in terms of sources of cash generation and
funding.

Figure 1: Standard DCF valuation framework – cash generation and funding

SOURCES OF CASH GENERATION SOURCES OF FUNDING

Operating Equity
Fixed
Assets
Operating assets of the firm
Distribution of cash flows between debt
that generate free
and equity holders.
cash flows (FCF)

Operating Debt and equity holders want a return for their

Working investments primarily driven by the risk profile of
Capital Debt the operating assets (WACC)

Non-operating assets and

liabilities that generate non- Nonoper.
operating cash flows Assets &
Liabilities

MAIN VALUE SOURCES VALUE REDISTRIBUTION

Another way to present the DCF valuation is described as follows:

Valuation Manual

Figure 2: Standard DCF valuation framework

1. Determine the value

of the operating assets
based on a DCF
framework 3. Redistribute the value
between equity
and debt holders

2. Correct for the value

of non operating assets
and liabilities (not
incl. in FCF forecast)

PV (FCF) during PV Continuing Operating Excess cash Value non Value non Adjusted Value interest Equity value Value preferred Employee stock Value ordinary
PP Value enterprise value operating assets operating enterprise value bearing debt equity options shares
liabilities

WACC
EV

Cont.
FCF Value
FCF FCF
FCF FCF
time
Exit PLANNINGPERIOD PERPETUITY
Date

In order to generate the cash flow inputs for our DCF analysis we need to forecast the expected values for the
profit and loss account items as set out in Chapter 2, and then adjust them to reflect the cash flows expected to
derive from those items.
The most common methodology is to value the ‘unlevered’ or ‘ungeared’ free cash flow of the project – i.e. the
cash flows available for distribution to investors (both debt and equity providers) of any class after all other
expenditure and claims have been paid (‘free cash flow to the firm’). We can then adjust the valuation separately
for the mix of financing using WACC (described below). Cash flows of any frequency may be valued (e.g. monthly,
quarterly or annual) but for most purposes annual cash flows are adequate. Free cash flow to the firm is defined
as cash flows generated by the operating assets of the firm taking into account all investments in operating capital.
The figure below provides the basic calculation of the FCF according to most standard models.

Figure 3: Free Cash Flow calculation

FREE CASH FLOW Just link from

P&L and Balance
EBITDA Sheet
- Amortisation intangible fixed assets
- Depreciation
Operating profit before tax
Operating profit before tax *
- Operating taxes statutory tax rate(1)
NOPLAT
+ Amortisation intangible fixed assets
+ Depreciation + Increase in Inventories
GROSS CASH FLOW + Increase in Trade Receivables
+ Increase in Other Current Assets
- Change in operating working capital + Increase in Other Receivables (Operating)
- Capex in goodwill + Increase in Operating cash
- Capex Tangible Fixed Assets - Increase in Trade Payables
- Capex intangible fixed assets - Increase in Other Payables (Operating)
+ Increase in operating provisions - Increase in Current Tax Payable
CASH FLOW FROM INVESTING

FREE CASH FLOW = GROSS CASH FLOW - CASH FLOW FROM INVESTING

Note: (1) If a company generates results in multiple countries one should calculate a blended statutory tax rate
Valuation Manual

3.4 Explicit cash flow forecasts and the terminal value

In theory DCF methodology demands that cash flows should be forecast into perpetuity (or for as long as the
business is going to be in existence). This is impractical, furthermore it is unnecessary as once our forecasts reach
a ‘steady state’ we can create a ‘Terminal Value’ or ‘Continuing Value’. The Continuing Value is equal to the
Present Value of all the future cash flows till infinity at that point in time. This is then discounted back to the
valuation date and added to the Present Value of the explicit cash flows being generated over the explicit forecast
period.
It is normal to forecast out for c.10 years explicitly. A shorter period than this is unlikely to encompass an entire
business or economic cycle and, given that the Terminal Value is usually based on the last year of the explicit
cash flow forecast, could lead to considerable distortion of the true value. Especially when at the date of the
continuing value period, the company is not in the steady state and midpoint of the cycle. When forecasting the
financial statements, benchmark the forecasted financials of the company with key ratios of comparable
companies/industry averages to support/challenge your forecast assumptions on depreciation, capex, operating
expenses, taxation, working capital, debt, growth, margin trends and other key assumptions.
The terminal value often comprises a major part of the total Enterprise Value in a DCF valuation so great care
must be taken in calculating it. In order to cope with cyclicality of a business one should calibrate an explicit
forecast period to the mid-cycle. The mid or average cycle assumptions should be used as a basis for calculating
the continuing value.

Figure 4: Continuing value in a cyclical business

FREE CASH FLOW

Cycle
Average
Growth
Rate

EXPLICIT FORECAST PERIOD CV PERIOD

3.5 The valuation exercise

The theory
Having derived the free cash flows we must discount them at rates which reflect risk and the time value of money.
This is achieved by discounting at the Weighed Average Cost of Capital (‘WACC’). The WACC is calculated by
weighting the cost of equity and debt in the company’s financial structure according to their target market values
(note the circularity of using the value to calculate the WACC to calculate the value). In the WACC, the cost of
equity is the appropriate cost at the leverage assumed in the weighting process (i.e. if it is assumed that 30% of
the total capital structure is debt then the cost of equity should reflect 30% gearing).

Calculation of the WACC

The WACC is given by
WACC = ke x E ÷ TV + kd x (1 – Td) x D ÷ TV + khs x H ÷ TV
Valuation Manual

where
ke is the geared (levered) cost of equity
kd is the cost (to the firm) of debt
khs is the cost of hybrid security (such as convertible)
E is the value of equity in the capital structure
D is the value of debt in the capital structure
H is the value of hybrids in the capital structure
Td is the marginal tax rate

Due to the circularity noted above, the values of D and E are often set as targets, rather than as the market
values. These targets represent a supposed ‘optimum’ capital structure for the business, estimated by peer group
analysis or alternatively based on an estimate of the Debt to EBITDA multiple versus the average rolling
EV/EBITDA multiple (preferably over a few business cycles). Note that a business may contain additional sources
of capital to the equity and debt outlined above; any hybrid instruments, such as convertible debt and preferred
shares, would require adjustment to the WACC calculation as indicated in the formula. It is entirely acceptable to
model a changing WACC over time (due to changes in one or more of the elements). The WACC is discussed in
more detail in the Chapter 4.

3.6 Terminal Value

Necessity for the Terminal Value

As noted above we should forecast cash flows in perpetuity (or for as long as the business is going to be in
existence). This is impractical, and furthermore it is unnecessary as once our forecasts reach a ‘steady state’ it is
possible to create a ‘Terminal Value’ which is mathematically identical to the then Present Value of the future cash
flows being generated from that point in time. The continuing value is then discounted back to the valuation date
and added to the Present Value of the cash flows being generated in the explicit forecast period to create an
aggregate Enterprise Value for the business. As the continuing value is effectively calculated at the start of the
continuing value period, one should apply a similar discount factor as the present value calculation of the cash
flow at the end of the explicit forecast period.

Calculation of the Terminal Value using Perpetuity Method / Gordon Growth Model
If the cash flows are expected to grow in perpetuity at a constant rate (which may be negative) then this effect can
be replicated by use of a standard perpetuity formula with an infinite nominal growth rate in FCF of GCV:
FCFCV
CV =
WACC − G CV
where,
CV = Continuing value
FCFCV = Free cash flow in the first year of the continuing value period
GCV = Nominal growth of the free cash flows in the continuing value period
WACC = Weighted Average Cost of Capital

Whilst majority of DCF valuations use perpetuity method in some form, one should be careful using this
formula.
By adjusting the growth rate in the continuing value period, the capital expenditures that must accommodate this
growth rate, meaning the FCFCV, should change as well (higher capex, lower cash flows). The nominal growth rate
in the continuing value period equals inflation plus real growth where real growth depends on the level of capex for
growth (measured with RI) and the real return being generated on these new assets (driven by RONIC and
Inflation). In formula:
G CV = π + RI CV [RONICCV − π ] = RI CV × RONICCV + [1 − RI CV ]× π
where,
GCV = Infinite nominal growth rate in free cash flows in the continuing value
π = Long term inflation in the currency of the FCF
Valuation Manual

RICV = Long term reinvestment rate in the continuing value period

RONICCV = Long term nominal return on new investments in operating capital
The continuing growth rate (GCV) should never exceed the nominal growth rate of the economy or the industry
because such assumption would imply the company will become larger than the economy and/or industry in the
long term. Therefore GCV should be equal or lower than: real GDP growth + inflation or real industry growth +
inflation. The reinvestment rate (RI) shows the proportion of NOPLAT (Net Operating Profit Less Adjusted Tax)
being reinvested in the business for growing the business and reflects in fact the level of spending in growth (“new
investments”). The difference between NOPLAT and FCF is equal to new investments, hence the reinvestment
ratio:

NEW INVESTMENT NOPLAT − FCF

RI = =
NOPLAT NOPLAT

In order to validate your steady state assumptions one should compare the reinvestment ratio in the explicit
forecast period with the continuing value assumption.

Figure 5: Transition from explicit forecast period to CV period

Smooth transition from explicit forecast period to CV period Not smooth transition from explicit forecast period to CV period

 RICV RICV

Explicit forecast period Continuing value period Explicit forecast period Continuing value period

The RONICCV reflects the nominal return being generated on new investments in the continuing value period,
ROIC will migrate to the RONIC in the continuing value period. In competitive industries the RONICCV should be
equal to the WACC as it is not possible to generate excess returns into perpetuity in these industries. In other
words, the company will make only zero NPV projects in the continuing value period. This will drive the ROIC to
the WACC in the continuing value period. When a firm has a sustainable competitive advantage till infinity (e.g., a
monopoly due to access to unique resources) it is possible to have a RONICCV above the WACC. This implies that
the company will sustain to create value after the planning period (NPV > 0).

Figure 6: Value creation in the CV period

DEVELOPMENT RONIC AND ROIC DEVELOPMENT RONIC AND ROIC
ASSUMING NO VALUE CREATION IN CV PERIOD ASSUMING VALUE CREATION IN CV PERIOD

RONIC
RONIC

ROIC
ROIC

SPREAD
WACC
WACC
Explicit forecast period Continuing value period Explicit forecast period Continuing value period

Assuming that most companies operate in competitive industries and excess returns will diminish on the long term,
you would expect that the RONIC during the explicit forecast period will migrate to the WACC. Similar to the
reinvestment ratio, try to achieve smooth patterns of RONIC in the steady state phase of your explicit forecast
period. The RONIC during the explicit forecast period can be derived implicitly from your forecast. In formula:
NOPLATt +1
- 1- π
Gt,t +1 - π NOPLATt
RONICt = +π= +π
RIt RIt
The CV formula as stated earlier FCFCV / (WACC - GCV) could be rewritten as we have derived the following
formulas for free cash flow and growth rate in the continuing value period:
Valuation Manual

FCFCV = NOPLATCV x [ 1 − RI CV ]
G CV = RI CV × RONIC CV + [1 − RI CV ]× π

The CV formula could therefore be rewritten as follows:

NOPLATCV [1 − RI CV ]
CV =
WACC − [RI CV × RONICCV + [1 − RI CV ]× π ]

Where NOPLATCV = NOPLATT x [1+GCV]

Where in case of no value creation in the continuing value period, i.e. RONICCV equals WACC, the CV formula is:
NOPLATCV
CV =
WACC − π

Perform sanity checks

When analysing the Terminal Value of a business always perform the following sanity checks
 What is the implied EBIT(D)A multiple derived from the terminal value
o if it is too high – you are probably underestimating recurring capex
 Is it possible for this business to create value in the continuing value period (WACC vs RONICCV)?
 Do the projected financials in the last year of the explicit forecast period reflect a steady state?
 Is there a smooth transition of RI and RONIC from the explicit forecast to the continuing value period?
 Does the growth rate make sense:
- Growth rate of the company should not exceed growth in industry and economy
- Growth rate should at least be equal to inflation

Alternative ways of deriving a Terminal Value

Exit multiples
As noted above, the TV simply replicates a full DCF calculation at the time of the last cash flow – i.e. the
enterprise value of the business. Logically we could therefore arrive at a similar value by consideration of the usual
multiples of profit and loss items (e.g. sales or EBITDA). However, in applying such multiples you should note that
you are trying to judge how the market will value the company in c.10 years' time – this raises the difficulties of
both trying to judge the market reaction to what may be a radically different company (we would generally assume
it has gone ex-growth by the end of Year 10 and thus trade at lower multiples) and the appropriate multiples to
use. A multiples based terminal value is a good sanity check to the perpetuity method as described above. A
sensible approach is to take the rolling average of the multiple over preferably a few business cycles.
Liquidation approach
A less common method to calculate the TV is using a liquidation approach, assuming liquidation at the end of the
explicit forecast period. At the end of the forecast period one should determine the liquidation value of the tangible
assets in the company.

3.7 Discounting free cash flows and continuing value

Year-end vs mid-year discounting

In order to calculate the present value of cash flows and the continuing one should discount all cash flows to the
WACC. It is often assumed that the free cash flows are realised at the end of a forecast year hence one tends to
apply year end discounting with a factor 1/(1+WACC)t where t = { 1, 2,…….T }. It can be argued that on average
cash flows are generated gradually during the year hence mid year discounting is more accurate; discount factor
at 1/(1+WACC)t where t = { 0.5, 1.5,…….}. Note that the difference between year end and mid year discounting is
equal to (1+WACC)0.5 -1 ≈ WACC/2.
Valuation Manual

Seasonal pattern of cash flows

In case cash flows show strong seasonal patterns it is recommended to break down the annual free cash flows
into quarterly/monthly cash flow and discount these with a quarterly/monthly discount factor. Please find below an
example of quarterly discounting.

Figure 7: Example quarterly discounting

FYR1 FYR2 FYR3 FYR4 FYR5 FYR6 FYR7

Annual FCF 100.0 105.0 110.3 115.8 121.6 127.6 134.0

Q1 30% 30 32 33 35 36 38 40
Q2 40% 40 42 44 46 49 51 54
Q3 20% 20 21 22 23 24 26 27
Q4 10% 10 11 11 12 12 13 13

Discount factor 12%

Q1 0.97 0.87 0.77 0.69 0.62 0.55 0.49
Q2 0.94 0.84 0.75 0.67 0.60 0.54 0.48
Q3 0.92 0.82 0.73 0.65 0.58 0.52 0.47
Q4 0.89 0.80 0.71 0.64 0.57 0.51 0.45

Discounted FCF 94.3 88.4 82.8 77.7 72.8 68.3 64.0

=> Using sumproduct

3.8 From present value of FCF to equity value

After determining the present value of the free cash flows and the continuing value, the resulting Enterprise Value
should be corrected for all non operating assets and liabilities, not included in the FCF forecast to derive the value
to be distributed between the equity and debt holders.

Figure 8: Standard DCF valuation framework

1. Determine the value

of the operating assets
based on a DCF 3. Redistribute the value
framework between equity
and debt holders

2. Correct for the value

of non operating assets
and liabilities (not
incl. in FCF forecast)

PV (FCF) during PV Continuing Operating Excess cash Value non Value non Adjusted Value interest Equity value Value preferred Employee stock Value ordinary
PP Value enterprise value operating assets operating enterprise value bearing debt equity options shares
liabilities

Valuation of non-operating assets and liabilities

All assets and liabilities that are not included in free cash flow have to be valued separately and
adjusted for in the present value of FCF and continuing value. Non operating assets (positive value adjustments)
include a.o.:
 Marketable securities and excess cash
 Financial fixed assets
Valuation Manual

 Value of stakes in associated companies

 Value of off balance sheet derivatives
 Value of deferred tax assets

Non operating liabilities (negative value adjustments) include a.o.:

 Non-operating provisions not included in FCF
 Pension deficits
 Retirement related liabilities
 Value of minority stakes
 Derivatives and employee stock options
 Value impact of lawsuit obligations
 Value of tax liabilities/deferred tax provisions

Be careful using the book values for these assets as these may significantly differ from the fair/ market value.
Valuation Manual

Value adjustments for pensions

There are two types of pension schemes; defined contribution and defined benefit plans.
 Defined contribution plans: these schemes define the contributions that the employer will make to the fund on
behalf of the employee. Once the transfer is made then no further obligation rests with the company. The
residual risk remains with the employee. The contributions will be charged as an operating expense and
should be forecast accordingly when modelling personnel costs. No separate value adjustments are
necessary
 Defined benefit plans: these schemes define the targets to be paid to employees on retirement in the future
hence the company is obliged to provide specific retirement benefits to the employees irrespective of the
actual performance of the fund. Normally the target is set as a fraction of final or mid salary. The residual risk
remains with the firm and the valuation implications are quite complex

Defined benefit plans can either be funded or unfunded.

Funded pension plan

In case of a funded pension plan the firm invests the pension premiums received from the employees in a special
fund. The difference between the value of the pension fund assets and pension plan obligation is recorded on the
balance sheet. Two situations can occur:
 Overfunding/surplus: pension fund asset > pension benefit obligation >> asset, positive adjustment to EV
 Underfunding/deficit: pension fund asset < pension benefit obligation >> liability, negative adjustment to EV

The adjustment on the DCF derived EV for funded pension plans is as follows 2:
Plus: [Fair value of the pension assets – Fair value of the pension benefit obligation][1-Tc]

Where the adjustment for [1-Tc] reflects the related deferred tax asset/liability in case of a pension deficit or
surplus.

Unfunded pension plan

In case of an unfunded pension plan, the firm does not separately invest the pension premiums in a fund but these
are reinvested in the business. Only the pension benefit obligation is separately shown on the balance sheet and
should be treated as a debt-like item. The adjustment on the DCF-enterprise value for unfunded pension plans is
as follows:
minus Recorded value of pension benefit obligation

If significant, the negative adjustments made for the pensions in the valuation could be treated as a debt
component in the WACC.

Value adjustments for derivatives

For valuation purposes adjust the enterprise value for the fair market value of the outstanding derivatives and treat
it as a non-operating asset or liability. Make this adjustment only if the effects of the derivative are not included in
the free cash flows. Future derivative positions are irrelevant for the valuation as we may assume
that they have a zero NPV hence not affecting firm and equity value.

Value adjustments for employee stock options

Under IFRS, the costs of employee stock options (ESO) should be expensed in the P&L under
personnel costs at fair market value although it is not a cash out at the grant date. For valuation purposes the
following adjustments have to be made at:
 Outstanding ESOP at valuation date: calculate the fair value of the outstanding ESO and treat it as a debt-like
item when calculating the value to the ordinary shareholders. Use an option valuation model for example
Black/Scholes/Merton-framework

2
If the differences between (un)recognised under/overfunding are already reflected in the forecasted service costs (e.g.
higher forecasted service costs due to large deficits), these adjustments are not necessary as they are already reflected in the
FCF hence valuation
Valuation Manual

 ESOP to be granted in the future: include the projected cost of ESO to be granted in the future in the FCF and
treat it as if it is comparable to a cash bonus although in reality it is not. For valuation purposes, assuming the
cost of future ESO is a cash out, will then properly reflect the value transfer to it’s employees

Value adjustments for preferred equity

In case preferred stock is traded one should always use market value to value the preferred stock. If the preferred
equity is not traded, the value could be determined based on DCF analysis.
Constant dividend: Vprefs = E(dividends)/kp
Constant growing dividend: Vprefs = E(dividends)/[kp-g]

3.9 Sensitivity analyses

In a basic model we focused on discounting the expected free cash flows with the WACC. The cash flow forecast
is based on expectations, i.e. the mean of all possible outcomes. However under uncertainty the realisation of
cash flows differs from expectation. Although market risk is addressed in the valuation, priced in via the WACC, it
is very useful to understand which key value drivers affect the valuation of a company.
Through a sensitivity analysis, the key value drivers of a business and subsequent impact on cash flow/valuation
can be identified. It also helps to focus attention of management to estimate, monitor and manage most important
drivers of the business and could lead to new creative insights and alternative views with respect to the company
(e.g. conservative versus aggressive price policy).
Possible disadvantages of a sensitivity analysis could be negation of interdependencies between value drivers
when not explicitly modelled (for example increase in sales price will also influence the quantity sold) and it
neglects the level and effort management must put in to influence a value driver (e.g. a one percent change in
market share vs one percent change in creditor days).

Figure 9: Example of a sensitivity analysis

% change in enterprise value from a 1% change in …...

Inventory days
Enterprise value most
sensitive to changes in
Capex market share, long term
FCF growth and WACC

Revenues/FTE

Production
cost/unit

Tax rate

Price per unit

WACC

CV grow th

Market share

0.0% 2.0% 4.0% 6.0% 8.0% 10.0%

Through the table function in Excel sensitivity analyses can easily be performed.
Valuation Manual

4. Weighted Average Cost of Capital

4.1 Cost of Capital

In the previous chapter we saw that for a DCF valuation it is necessary to identify and quantify the following
parameters:
 FCF Free Cash Flow to firm
 re Cost of equity
 rd Cost of debt
 Td Corporate tax shields arising from debt financing
 E and D Capital structure and weightings

4.2 The cost of equity

The Capital Asset Pricing Model is normally used as a basis for calculating the cost of equity.

CAPM theory
The portfolio theory underlying the CAPM holds that investors only require a return for the non-diversifiable risk of
the market. This risk will vary according to both (i) the nature of the business' operations and (ii) the financial risk
introduced by gearing (leverage). This variability is captured by a factor termed ‘beta’ (βe). The returns equity
investors require to compensate for this non-diversifiable risk may be expressed mathematically as:

re = rf + βe x (rm - rf) + SFP + ILP

Where:
re = required return to investor (pre-tax), which is therefore cost of equity to the business;
rf = risk free rate;
βe = the geared equity beta;
(rm - rf) = the market risk premium (“MRP”)
SFP = small firm premium
ILP = illiquidity premium

rf, the risk free rate

The risk free rate is the return investors require when they invest in a financial instrument that has no default risk.
There is only one risk free rate in the world, otherwise there would be arbitrage to correct the difference. However,
unfortunately this rate is impossible to measure directly. The US treasury, and UK government, which both have
hundreds of years without default and are thus meaningfully ‘risk free’, are measured in local currency. From the
viewpoint of a non-US Dollar investor, the US treasury rate has currency risk attached. The same is true of the UK
for a non-Sterling investor.
In theory the best risk free rate is the return on a zero coupon government bond with no default risk matching the
cash flows being valued. This translates into using different risk free rates for each cash flow - the 1 year zero
coupon rate for the cash flow in year 1, the 2-year zero coupon rate for the cash flow in year 2 etc. Practically
speaking, if there is substantial uncertainty about expected cash flows, the present value effect of using time
varying zero coupon risk free rates is small enough that it may be ignored. For corporate valuation a yield on a
long term government bond with high liquidity (10 year government bond) can be used as this matches the
average duration of the cash flows being valued.
In case cash flows are modelled in euro’s one should use the 10 year German government bond (Bundesbund) as
Germany is considered a risk free country. The rate can be sourced from Bloomberg (code: GGR <Go>) or
Datastream (code: GBBD10Y).
If one is modelling in other currencies, careful thought should be given to ensure that rf is risk free. If it is not, risk is
being transferred from the (rm - rf) part of the equation to the rf part, meaning risk will be understated for high βeta
companies and overstated for low βeta companies. One good approach: yield 10yrs German Government Bond
plus adjustment for inflation difference between local currency versus Euro.
Valuation Manual

Market risk premium

The MRP reflects the extra return over the risk free rate that investors demand exposing themselves to a market
risk. It is the value weighted average premium all investors demand per unit of market risk.
In formula: MRP = E(rm) – rf
The MRP depends on
 Level of risk aversion of investors: the higher the risk aversion the higher the MRP (risk aversion changes at
different levels of wealth and economic prosperity)
 Risk of the total market: the higher the overall market risk the higher the E(rm)
There seems to be evidence that MRP does not differ significantly across well developed countries because
capital markets are increasingly integrated and investors invest more and more international. In a survey among
200 academic economists Ivo Welch (1999) and recent studies found that the equity premium in well developed
countries tends to be 5 to 6% 3.

Beta
Beta is a measure of covariance; the degree to which the returns of an asset move with the market return and thus
reflects market risk. The beta shows whether a company is more or less risky than the market:
 Beta = 1.0; implies that when the market went up (down) 10% on average the stock also went up (down) 10%
 Beta = 0.8; implies that when the market went up (down) 10% on average the stock also went up (down) 8%
 Beta = 1.2; implies that when the market went up (down) 10% on average the stock also went up (down) 12%
The standard procedure for estimating historical betas is to regress stock returns against market returns. The
slope of the regression corresponds to the beta of the stock, and measures the riskiness of the stock.
Ri = a × β + Rm
where,
a = intercept
β = slope of the regression, cov(Rj,Rm)/Var(Rm)
Ri = (Div.+Pt=1-Pt=0)/Pt=0
Rm = Div. Yieldm+(Indext=1-Indext=0)/Indext=0

The selection of the time horizon and the sampling interval also have an impact on the value of the measured
beta. In practice often monthly return intervals are used as this mitigates some of the effects of thinly traded stock.
One can determine the raw beta by regressing the total returns of the company’s shares in Euro with the MSCI
World Index also in Euro. If the marginal investor is a local investor one could better use a local index however we
assume that the price setting investor tends to be a global investor. A three year time frame will result in sufficient
data points and should better reflect the current systematic risk profile of the business. Through the built-in
regression function in Excel one can easily calculate the beta of a particular stock (Tools > Data analysis > select
Regression or via the slope function).
In order to sanity check the beta’s derived from your regression analysis the following sources for beta’s can be
checked: Value Line, Datastream, Thomson, Bloomberg and Barra. Please keep in mind that in the default beta
estimation these sources use the local index as market portfolio.
If a share is thinly traded one should use monthly/weekly returns over a 5 years historical period. To determine
whether a share is thinly traded one could analyse:
 Daily/weekly volume vs outstanding shares
 Daily/weekly volume vs free float
 Free float vs outstanding shares
 Bid/ask spread
Please keep in mind that analysing historical beta’s will only work for traded firms that did not significantly changed
their activities, operating leverage and financial leverage over the historical period. The beta calculated or
observed, whatever its source, will be the equity beta, i.e. it combines the effect of both financial risk and operating
risk. For the purposes of comparison we are interested in operating risk, therefore it is necessary to adjust the beta
for the effect of financial risk to derive the asset-, unlevered- or ungeared beta.

3
These findings are however still debated. Other researcher found the following MRP for developed countries. Damodaran
(2000): 5-6%; Copeland, Koller and Murrin (2000): 5.0%; Brealey and Myers (2000): 6-8%; Harvard Business Review (1995):
5-7%; Copeland: 5.5%; Stern Stewart: 6.0%
Valuation Manual

The principal formula employed in this process is the relationship between a company's betas, as follows:
Asset beta = (proportion of debt x debt beta) + (proportion of equity x equity beta)
or:
D E
βA = × βD + × βE
D+E D+E
Where:
βA = the asset or business beta;
βE = the geared equity beta;
D = value of net debt; and
E = value of equity
Betas, as mentioned earlier, give an indication of risk and the asset beta calculated from the formula above gives
an indication of the risk of the assets. The risk of the assets in an ungeared state can be determined by calculating
the equity contribution to βA. In the presence of corporate taxes, the final formula (Hamada-formula
6
) is thus:
β A = β E /[1 + (1 − Tc ) × D/E]
where:
Tc = tax shield on debt
Using this equation we can restate observed betas for different comparable companies, unlever those betas (from
the financial structure in their companies with the debt defined as net debt) and relever them (at the target’s
financial structure with the debt defined as gross debt) to give an estimated appropriate equity beta (see formula
below). The tax rate should be defined on a marginal basis, hence should reflect the level of tax deductibility that
can be realized on the interest costs going forward.
The target debt ratio
The debt ratio chosen for the company to be valued is inevitably subjective. In the first instance peer group
analysis of both debt ratios and asset betas will suggest whether the business risk is low or high. Supportable
financial risk will be an inverse function of the business risk. It is possible that due to business cycles or other one-
off events gearing at the balance sheet dates for otherwise comparable companies will be unrepresentative. The
data should always be reviewed critically with this in mind.
The following rules for determining unlevered betas should be used. First identify proper peers to be used for
ungearing betas and determine the historical equity betas of these companies. The average of betas derived from
3 year weekly and monthly returns can be used. Secondly determine the average market based net debt/equity-
ratio of peers corresponding with the timeframe of calculation of historical equity betas. The net debt/equity ratio
can be derived from Thomson/Bloomberg. Thirdly one should determine the average marginal tax rate of peers
corresponding with the timeframe of calculation of the historical equity betas. As the marginal tax rate on debt
often matches the statutory tax rate, it is recommended to use the statutory tax rate and not the effective tax rate.
The statutory tax rate can be sourced from the KPMG Tax Survey report. The final step is to calculate the
unlevered betas of the individual peers, remove any outliers and take the median of the peer group.
Regearing the beta
The asset beta formula referred to the above can be re-arranged to give4:
β E = β A [1 + (1 − Tc ) × D/E]
βE can now be calculated since the variables βA, D, E and Tc for the company in question are known. Please note
one should determine the gross debt/equity-ratio based on market values of the company one is analysing. Gross
debt should be taken as excess cash going forward will probably be paid out as dividend or used for share
buybacks. In addition one should determine the average statutory tax rate the company will incur going forward.
However, often the current tax rate is used unless there will be a change in statutory tax rates that is already
known.

Small firm premium

Empirical studies have shown that small firms tend to generate higher returns than large companies. This has
been studied by a.o. Fama and French (1992). Although some of the size effect can be explained by higher betas
for small firms vis-à-vis large firms, the CAPM framework still underestimates equity returns of small companies.

4
Hamada assumes the beta of tax shields equals zero
Valuation Manual

The small firm effect stems from the fact that regression betas do not capture all systematic risk characteristics of
small firms; operational leverage tends to be higher for small firms and distress premiums tend to be larger for
small firms representing a shadow cost, hence a value discount. A small firm premium (SFP) in the cost of equity
results in a valuation discount as expected cash flows will be discounted at a higher rate. The figure below
provides an overview made in a study by Ibbotson of small firm premiums in relation to the Equity Value of a
company (rounded figures used).

Figure 10: Small firm premium above CAPM return

Premium above CAPM

5.0
4.0
4.0
3.0
(%)

1.8
2.0
1.0
1.0
0.0
0.0
<370 370 - 1,185 1,185 - 4,593 >4,593
Equity Value (€m)

Illiquidity premium
The illiquidity discount stems from the fact that shares of listed companies can be traded easily, rapidly, with price
certainty and with a minimum of transaction costs whereas for illiquid equity stakes it can be restricted or a lengthy
and costly process. The illiquidity discount depends on the type of illiquidity; whether the asset is privately held or
publicly traded, whether there are restrictions on the sale of the instrument and whether the market for the
investment is thin or active. In general two approaches are used for coping with illiquidity:
 Discrete percentage: subtract 10-30% from the equity valuation no adjustments for illiquidity in the discount
rate (Courts often use 10-25% as an illiquidity discount)
 Discount percentage: add 2-4% to the CAPM cost of equity and make no further illiquidity adjustments in the
valuation (Mercers model (1997))

4.3 The cost of debt

Introduction
In general the cost of debt is influenced by the following five risk factors:
 real interest rate risk: the risk that real interest rates will increase
 inflation risk: the risk that inflation will increase
 market risk: sensitivity of debt returns to the market
 default risk: the risk that the debt issuer will default
 liquidity risk: the risk that the debt holder will not be able to liquidate their investment in a timely manner
Valuation Manual

Figure 11: Cost of debt influenced by risk factors

Cost of debt

Risk premium

Market, default and

liquidity risk
rf

Interest rate and

inflation risk Risk free rate

Uncertainty FCF,
Capital structure

To determine the appropriate cost of debt one should follow the following steps. In case the debt of a company is
publicly traded, use the expected yield to maturity of the publicly traded debt. In case you can estimate the
(synthetic) bond rating, use the expected yields on traded bonds with similar ratings. If you can not estimate this
one should ask the banker involved or review recent borrowing spreads being paid.

Publicly traded debt

For investment grade bonds (rating > BBB, above investment grade) the cost of debt is approximately equal to the
promised yield to maturity matching the duration and rating of the debt. In formula this is:
n
Coupon t + Redemption t
MV(debt) = ∑
t =1 (1 + promised yield)t
For high yield bonds (rating < BBB, below investment grade), the cost of debt should be based on the expected
yield to maturity matching the duration and rating of the debt.

n
E(Coupon t ) + E(Redemption t )
MV(debt) = ∑
t =1 (1 + expected yield)t
where,
E(Coupon) = (1 − p) × Coupon + p × (1 − LGD) × Coupon
E(Redemptions) = (1 − p) × Redemption + p × (1 − LGD) × Redemption
p = default probability
LGD = loss given default
Estimating the default probability (p) and loss given default (LGD) for below investment grade debt can however
be quite difficult. Therefore to estimate the cost of below investment grade debt one can use the following
approximation based on “Valuation” of McKinsey:

kd = risk free rate + credit spread BBB + βdistress MRP

Where βdistress equals the difference of the beta of above investment grade debt vis-a-vis below investment grade
debt (estimated to be around 0.1). Therefore assuming an average midcycle MRP of around 5.5% the cost of
below investment grade debt equals:

kd = risk free rate + credit spread BBB + 55bps

where, the risk free rate is approximately equal to the yield on a 10 year government bond. The cost of debt for
above investment grade companies should be equal to the yield on a 10 year government bond plus the credit
spread. The relevant rating of a company can be found in Bloomberg (code CRPR).
Non-traded debt
Valuation Manual

In case debt is not traded one could estimate the cost of debt by determining a synthetic rating and derive the
accompanying credit spread. Based on a number of ratios as being used by rating agencies (e.g., Net
debt/EBITDA, EBITDA over cash interest etc.) rating tables for different sectors can be made and these can be
compared with the ratios of the specific company to determine the (synthetic) rating. Please note the credit ratio
differs significantly per sector so sector differentiation is advised.
In case it is impossible to determine a synthetic rating one could use the credit rating of a comparable peer (similar
in terms of size, profit and leverage) or use an industry rating.
If a company has more than one debt instrument, theoretically the average cost of debt should be based on a
bottom up approach by finding or calculating the expected yield to maturity for each individual instrument and use
market values of each instrument to weigh each instrument’s yield and produce an average. In most instances
however the cost of debt will be based on the companies rating and no bottom up approach is used.

4.4 The effect of tax on the cost of debt and equity returns

The tax shield on debt

As interest on debt is usually a tax-deductable expense, a tax shield is generated on interest payments which can
be deducted from the corporate tax computation as follows:
Tdt = i t x tt

where Tdt is the tax shield, it is the interest expense and tt is the marginal rate of tax at time t.
Whilst this is comparatively simple, it is worth noting that the marginal tax rate should in fact be the tax rate to
which the tax shields on interest are realised. Often the statutory tax rate is used as a proxy for the marginal rate
however as studied by Graham it is estimated that the marginal tax rate is on average 0-5% points below the
statutory tax rate as a consequence of not fully utilising the tax shields on interest . If the firm does not pay taxes
over some period of time (e.g., because the firm has large tax loss carry forwards), there is a delayed tax
advantage on debt financing. In such a situation it may be better to use the APV-method and separately value the
tax shields on interest.

4.5 Capital structure and weightings

To recall the weighting factors in the WACC formula comprise:
E/TV = target equity value in total firm value
D/TV = target debt value in total firm value
H/TV = target value of hybrid securities in total firm value

Weightings in the WACC should be based on market values, because these represent the true economic claims
the investors have on the company and would like to receive a return over. The target debt level should be stated
on a gross debt level basis and not on a net debt basis as it is very likely that excess cash going forward will be
used for dividend payout or share buybacks. However, if you know with quite some certainty that the company will
sustain substantial levels of excess cash going forward it is allowed to use net debt.
In case the current capital structure differs significantly from the target capital structure you may take the migration
of the capital structure into account, resulting in a time varying WACC.
One could determine the market value based target capital structure by analysing statements made by
management on their policy for the company’s capital structure or use the average capital structure of the peer
group or industry.
Management policy on capital structure
In case management has stated a target leverage multiple, for example Debt/EBITDA of 3.0x going forward, then
one could take a view on the long term Enterprise Value/ EBITDA, say for example 10.0x and subsequently derive
the target capital structure (i.e. D/TV = 30% and E/TV = 70%). Another way to determine the target capital
structure based on management policy could be done if management has stated targets in book value. For
example management targets a debt / [ debt + equity ] ratio of 40%. If you take a view on the long term expected
MTB ratio of for example 2.0x, the derived capital structure will be D/TV = 25% and E/TV = 75%.
Average capital structure of the industry/ peer group
If management did not give clear indication on their capital structure going forward one could always determine the
target structure based on the peer group/industry (historical or average). Alternatively, one could use the multiple
approach as discussed above for the peer group/industry instead of one individual company.
Valuation Manual

5. Multiple valuation

5.1 Introduction
The analyses of the trading values of comparable companies (CoCo) and the values paid for the whole
businesses in transactions (CoTrans) are essential valuation tools.
Multiples, essentially a ratio measuring value against some objective criteria, such as sales, are calculated and are
then applied to some criteria for another company, whether quoted or unquoted, to derive an implied value. As
well as referring to standard financial criteria such as sales and operating profit, multiples can also be calculated
with reference to various industry specific criteria – e.g. EV/subscriber in telecoms, sector or EV/funds under
management in financial services industry. Recognising the subjectivity and inherent errors of the approach,
multiples are usually stated as ranges rather than as absolute figures.
The use of multiples provides you with a quick and dirty methodology to get a first idea of the company’s value. In
addition one should use multiples as a control methodology, to assess whether the DCF is in line with market
comparables or comparable transactions.
There are essentially two different sources for multiples:
(a) Comparable companies – multiples are calculated by reference to the market valuation of quoted companies
which are deemed suitable comparables for the company being valued.
(b) Comparable transactions – multiples are calculated by reference to the reported deal values of recent
(completed) transactions which are deemed suitable comparables for the company being valued.
The bulk of this section has been prepared from the perspective of comparable companies rather than comparable
transactions. Both the theory and practice of the two types are broadly similar, although a few points specific to
comparable transactions are summarised later on.

5.2 Enterprise value vs market capitalisation

A crucial distinction needs to be drawn between enterprise value multiples and market capitalisation (or equity
value) multiples. Enterprise value (‘EV’) is the value of the whole business, regardless of financing structure
Market capitalisation represents only that part of the value of the whole business that is claimed by equity holders.
It is therefore the residual after the claims of debt provided, minority shareholders and, arguably, those entitled to
pensions and similar liabilities.
When calculating and applying multiples, it is essential to use the appropriate measure. The vast majority of
multiples (e.g. sales, EBITDA, EBIT, employees, capacity) should be calculated based on EV not market
capitalisation because the data represent returns attributable to all forms of finance in a business. For example,
EBIT is ‘attributable’ to both equity and debt holders and therefore it makes no sense to calculate a multiple of
EBIT solely to market capitalisation. Multiples which should be calculated by reference to market capitalisation are
those which are truly attributable only to equity holders (e.g. P&L measures after interest payments, such as PBT
or net profit, or BS measures excluding debt, such as net assets).
It is important to understand the general matching principle between the numerator (top) and the denominator
(bottom) of a multiple – why does Market cap/Sales make no sense? (answer – sales are generated by all forms
capital, both debt and equity).

5.3 Accounting for subsidiaries, associates and investments

Subsidiaries – full consolidation

Broadly speaking, when a company owns over 50% of another company, it becomes a subsidiary, and should be
fully consolidated onto the parent company’s accounts. Consolidating an entity means adding 100% of its assets
and liabilities to the assets and liabilities of the parent company, line by line. Full consolidation is therefore
sometimes called line by line consolidation. If ownership of the fully consolidated subsidiary is less than 100%,
however, this would over state the total assets of the business. A liability must therefore be added on the balance
sheet, called minority interests. This represents the net assets of the subsidiary which the parent does not actually
own. Thus, full consolidation of entities which are not fully owned creates minority interests.

Associates – equity accounting

When a company owns between 20% and 50% of another company, it is generally accounted for as an associate
and equity accounting is used. Equity accounting is sometimes referred to as ‘single line consolidation’ – for the
reason that the investment is all wrapped up into one entry on the Balance Sheet (investment in associates) and
Valuation Manual

one entry on the Profit and Loss (income from associates). Under the equity method, the purchaser records its
investment on the Balance Sheet at original cost (and increases this with income and decreases for dividends
from the subsidiary that accrue to the purchaser) and records its share in the profit after tax from the associate in
‘income from associates’ line item. Clearly – this method results in far less information on the investment being
disclosed (as all information on sales, margins, interest etc is collapsed down into one line on the Profit and Loss
representing profit after tax – income from associates - and all information on different asset and liability classes is
collapsed down into one line on the Balance Sheet – investment in associates).

Investment – at cost
If a company owns less than 20% of another company, it is accounted for as an investment using the cost method.
The company does not need any entries to adjust this account balance unless the investment is considered
impaired or there are liquidating dividends, both of which reduce the investment account.

5.4 Treatment of minority interests and income from associates in multiples

Minority interests
As discussed above in the section on Enterprise Value, the ‘matching principle’ should be used when assessing
whether to include or exclude minority interests in the calculation of your multiple. If financials on the denominator
(e.g. EBITDA, sales etc.) include 100% of the results generated by the subsidiary (as is the case with full
consolidation), then the numerator (EV) needs to include the capital provided by those minority interests.
Therefore, the value of a minority interests should be added to market cap and net debt in EV calculations.
One might ask, instead of adding minority interest to derive to an Enterprise Value, why don’t we just subtract the
portion of sales or EBITDA that the parent does not own. In theory, this would indeed work and may in fact lead to
a better analysis of the corporate in question. However, typically we do not have enough information about the
subsidiary to do such an adjustment. Moreover, even if we had the financial information, this method is clearly
more time consuming. Of course, if we are calculating a multiple ‘below’ minority interests, e.g. price-earnings (to
ordinary shareholders) then market cap without minority interests, is used in the multiple calculation process.

Income from associates

When considering income from associates, the same thought process should be applied. Is the income from
associates in the denominator (sales, EBITDA etc)? If yes, then the normal EV calculation applies (as the market
cap will incorporate value for the investment in associates – because income from associates flows down to profit
attributable to ordinary shareholders). More often than not, however, the answer is no, as income from associates
is ‘below’ EBIT in the P&L. As such, in theory, the market value of the investment in associates should be
deducted from EV when calculating multiples with metrics that exclude the financials of the associated company.
In practice, this level of detail in calculating multiples is only applied when investments in associates are material
part of the business. In addition, often the book value of the associated company is often used as a proxy for the
market value. Again, we could try and include income from associates in our financial results (sales, EBITDA etc)
– however we typically do not have enough information to do this. Remember that income from associates
represents the parent company’s share of the profit after tax of the associated company. How would we be able to
‘gross this up’ to EBITDA, or indeed sales, with just this one piece of information? If further information is available
however, for example, if we know the PAT margin, we could estimate sales from associates and add this to the
parent’s sales. In this case, the market value of investments in associates need not to be deducted from the EV.

Common practice
Note – many practitioners will not make adjustments to the EV for income from associates, and will instead just
include it as a form of interest income below EBIT. Whilst this is theoretically incorrect – the impact is often
immaterial. Bear this in mind when reconciling to broker’s calculations.

Best practices
 Market Capitalization – 1) double check Thomson market capitalization with that of Bloomberg, 2) check for
multiple share classes 3) adjust for known in-the-money stock options for employees
 Net Debt – 1) use the latest reported financial debt, 2) deduct excess cash (or total cash if no adjustment can
be made) and marketable securities
 Other adjustments – 1) deduct the latest reported value for Associates (or when listed the current market
capitalization multiplied with the amount of shares), 2) add value of Minorities, 3) make adjustments for any
other non-operating balance sheet items in line with DCF best practices
 Financials – 1) For latest reported data check with annual reports, and make adjustments for one-off items 2)
for forecasted data use broker consensus whilst keeping notice to the reporting date
Valuation Manual

5.5 General procedural rules

 Check that comparables are suitable – quality is much preferable to quantity. Analysts should develop a
genuine understanding of the comparability of companies, and select an appropriate short list. With multi-
discipline companies it may make sense to value different subsidiaries against different comparables
 Leave an audit trail – it is therefore imperative that a straightforward audit trail is left, as you go. Generally
speaking, a set of comps without a good audit trail is one with plenty of errors.
 Be consistent – above all, in preparing comparables tables be consistent throughout in the selection and
inputting of data.

5.6 Accounting inputs

 Using forecasts – relatively up-to-date broker reports should be used. In general, use consensus figures to
avoid using outliers. Ensure that the broker's forecast is written after the publication of any recent results or
major company newsflow. Also, be aware of any significant disposals or acquisitions since the most recent
results, for which an adjustment may have to be made. The note should, if possible, strike a balance between
being recent, comprehensive and representative.
 Normalising adjustments – the aim of a comparables table is to generate multiples that can be meaningfully
applied to the business to be valued. Consequently, any exceptional profits or losses (e.g. profits on property
disposals, write-downs of assets, provisions made or utilised) should be stripped out of both historic and
forecast numbers. In theory, this may also entail an adjustment to the tax line. However, this is often
impossible to establish without speaking to the company in question. If post tax figures are required,
adjustments based on the effective tax rate may be appropriate as an approximation.

5.7 Control premiums

Comparable company multiples are derived from the trading prices of individual shares. Such prices reflect the
negligible control rights (normally) associated with one share. Comparable acquisition multiples on the other hand
include a ‘premium for control’ paid to selling shareholders
The premium reflects
(i) the fact that any bidder must buyout all shareholders, not just those happy to sell at or below the market
price.
(ii) the fact that the bidder is buying not just the company on a standalone basis, but the opportunity to make
changes to the company at its discretion including potential synergies that may be reflected in the bid price.
When applying multiples, thought should always be given to how much of a control premium is built into the
multiple, depending on the situation, from a large public company with thousands of small shareholders to a hard
fought 100% acquisition, via public companies subject to market rumour and acquisitions of stakes which cross
certain (jurisdiction specific) thresholds.

5.8 Comparable transactions

As stated earlier, both the theory and practice of comparable companies and comparable acquisitions are broadly
similar. However, there are a few points which specifically relate to comparable transactions:
 The quality of information available on comparable transactions is often poorer. The principal problem is
identifying accurate figures for enterprise value and equity value. The ‘headline’ figure for a deal may or may
not include assumed debt and also the assumed debt may be substantially different from the figure at the
latest year end. The standard comparable transaction model forces a choice to specify whether debt is
assumed or not. Absent better information, a company bought from public hands will be bought assuming
debt, whilst a private sale would normally not involve the assumption of debt.
 The only reliable way to create a comparable acquisitions table is to obtain company-issued documents (e.g.
annual accounts, offer documents, press releases etc.). Annual accounts can be found in the UK via
Companies House. Third party databases are generally useful for identifying the deals and dates, but any
financial information obtained should be checked, (if possible), against other sources. Commonly used
sources include MergerMarket and Thomson One (SDC).
Once more, quality of deals is better than quantity.
International comparisons
Be aware of different accounting standards, and their effects on the multiples derived. Sales and EBITDA multiples
are often preferred as they are less subject to distortion
(i) across jurisdictions or
Valuation Manual

(ii) by management accounting policy choices

5.9 Rolling multiples

Rolling multiples are often used to understand cyclicality in multiples. One could calculate rolling multiples.
 Based on historical figures (for example: last twelve months; LTM) or
 Based on forward looking figures (for example: next twelve months; NTM)
Assumptions used in the historical multiple calculation include: Enterprise Value based on average Enterprise
Value during the historical year in relation to EBITDA based on realised EBITDA during that same historical year.
An alternative could be to show forward looking multiples for which one takes the Enterprise Value at the start of
historical year/quarter in relation to EBITDA based on the consensus estimate of EBITDA at start the start of that
same year/quarter.
An example of the development of rolling multiples for the waste sector is shown in the figure below.

Figure 12: Example of rolling multiples

Development of EV/EBITDA multiple

Average 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2000 - 2009
LTM 9.5 11.2 10.7 7.3 7.0 8.9 9.9 11.1 8.5 6.4 9.1
NTM 8.2 9.1 8.1 6.5 7.1 7.8 8.6 9.4 7.8 6.0 7.9

Rolling EBITDA analysis

14x
13x
12x
11x 10.8x
10x
9x
8x 7.9x
7x
6x
5.6x
5x
4x
Feb-00

Jun-00

Oct-00

Feb-01

Jun-01

Oct-01

Feb-02

Jun-02

Oct-02

Feb-03

Jun-03

Oct-03

Feb-04

Jun-04

Oct-04

Feb-05

Jun-05

Oct-05

Feb-06

Jun-06

Oct-06

Feb-07

Jun-07

Oct-07

Feb-08

Jun-08

Oct-08

Feb-09
LTM NTM MIN - NTM MAX - NTM Average NTM (00-09)

5.10 Other factors to consider

The following is a list of other common factors to consider when valuing a company based on multiples:
• Capital structure – does the company have a similar level of gearing to its peers
• Regulatory – does the company have any unusual regulatory requirements
• Capex – is the company at a similar point in its capex cycle
• Size of company – smaller private companies tend to be valued at a discount to larger quoted companies
• Liquidity
• Growth potential
Valuation Manual

6. LBO analysis

6.1 Introduction
The definition of a leveraged buyout (LBO) is often stated as the purchase of a company by a small group of
private investors with a limited investment-horizon, where the purchase price is financed with high levels of debt
that will be repaid from the target’s future cash flows as quickly as possible and where equity participation of
management is relatively high to align interests. The three main elements of LBOs are:
 A small group of private equity investors/financial buyers also called sponsors or promoters that acquire the
target together with existing/new management/ employees. Investors target to exit the company after a certain
holding period (normally at 3 to 5 years)
 Financing with high debt levels mainly against the future cash flows of the company with the objective to repay
the debt as soon as possible. High debt service levels will induce management to curb wasteful investments
and force improvements in operating performance
 Management are given incentives (via equity participation) to align their objectives with financial buyers
thereby mitigating agency costs
Financial sponsors in general look for companies with the following characteristics: high and stable cash flows,
attractive nature of the companies assets, a fat cost base, competent and experienced management, active in an
unconsolidated market, appropriate size (traditional route has been small to mid-sized takeouts up to €1.5bn),
ability to unlock breakup value and a visible exit within 3-5 years at an attractive exit price.
In generating sufficient returns on their investment, financial sponsors use the following hard factors to establish
this. Improvements in operating profitability through cost savings, revenue enhancements and group synergies.
Other factors include the reduction in operating capital by reducing working capital requirements and/or reducing
value destroying investments, make use of financial leverage and tax shields on interest expenses. Another
important factor could be multiple expansion/arbitrage through add-on acquisitions at a lower multiple than the
expected exit multiple or an exit of the target as a whole at a higher multiple than the entry multiple.
Research has indicated the sources of returns for financial sponsors are shifting over time, where operating
improvements and multiple expansion becoming more and more important while benefitting from financial
leverage becoming less important.

6.2 An LBO model

An LBO model provides a framework through which we are able to ascertain:
• The price the sponsor is able to pay for a business, given various financing constraints and minimum return
requirements; and
• The viability of an LBO at the current price, and how returns to equity holders might be optimised
The process is iterative in that the value an LBO places on a business depends on optimising the financial
structure which in turn depends on what purchase price needs to be financed. The model provides a logical
framework in which the returns for a particular value can be optimised.

Figure 13: Framework for determining the optimal LBO value

Estimate value

Reduce value Increase value

Optimise returns

Below minimum Above minimum

Returns on
finance

Returns sufficient

Optimal LBO value

Valuation Manual

6.3 Types of financing

An LBO model is constructed in the same manner as a business plan – operating assumptions (e.g. turnover,
margins, working capital etc) are projected in the same way.
With any LBO model, particular care has to be taken in dealing with the financing structure which invariably
contains a cross-section of sometimes esoteric types of capital.

Figure 14: Sources and Uses

Sources % Uses %
Tranche A 20% Purchase price of equity
Tranche B How will Newco 15% Redemption of existing net debt
be financed
Tranche C 15% Purchase price 95%
Total senior debt 50% How funds
will be used
Transaction costs 5%
Subordinated debt 15%

Equity 35%
Total consideration 100% Total consideration 100%

Descriptions of the different type of sources of financing are set out below. Please note that the mentioned
characteristics of the different debt items in this Chapter are based on current market views in normal market
circumstances.

6.3.1 Debt

The different types of debt financing instruments can be ranked based on return versus risk as indicated in the
figure below.

Figure 15: Risk reward trade-off of the different financing instruments

Quasi-
Vendor/shareholder loan2 equity3
(25-40%)

PIK / PIYC Notes

Return

Mezzanine Subordinated
debt
High yield bonds/notes (10-15%)

Stretch/Institutional Senior (Term loan B and C) Senior

debt
(50-60%)
Senior Bank Debt (Term loan A / Facilities1)

Risk

Notes: (1) For example revolver, capex- and/or acquisition facility; (2) Pricing of vendor and shareholder loan typically not in line with the risk-profile; (3)
Shareholder loan will be discussed under equity funding

Senior Debt
Senior debt has first call on the cash of the business in case of bankruptcy/insolvency, and may be secured on
assets. It is therefore the cheapest form of debt and, subject to current market limits, should be maximised in order
to raise equity returns. Senior debt is typically underwritten by banks and tends to be syndicated into the market
post transaction. Senior debt is secured against first charge over all assets and shares and has a term between 5-
Valuation Manual

9 years. If possible always check with a Leveraged Finance banker for the latest pricing on the different debt
instruments.
The senior debt package is usually split in three tranches:
 A tranche (senior bank loan) – general characteristics
- provided by banks (relationship driven)
- pricing interbank: +225 bps
- tenor: 7 years
- amortising
- average life of 4 to 4.5 years
 B and C tranche (institutional loans) – general characteristics
- provided by institutional investors
- pricing interbank: +275-325 bps
- tenor: 8-9 years
- bullet
- redemption of the B and C tranche should ideally not result in refinancing risk

Subordinated Debt
Various forms of subordinated debt (i.e. ranking behind senior debt), including mezzanine, high yield, second lien
and PIK notes can be used in an LBO capital structure – such debt ranks behind senior debt but before equity. In
general these instruments have tenors of at least 9 years.

Second Lien
Second Lien is also called last-out-tranche. Second lien is usually secured by collateral and repayment is by ways
of a bullet with tenor 9-10 years. Covenants are similar to senior debt. In general second lien amounts to around
5% of the total consideration. Cash interest paid on second lien is in general around 4.5 – 5% over EURIBOR.

Mezzanine Debt
This is a mixed form financial instrument layered in a company's balance sheet between equity and Senior Debt.
This is usually provided in the form of a subordinated loan with warrants attached which crystallise upon the sale
of the company. Mezzanine seeks to exploit the opportunity created by the substantial difference between the
risk/reward profile of senior debt and equity finance. Fairly normal characteristics might be:
 Bullet repayment and tenor at minimum of 10 years
 Covenants at 10% discount over senior
 Quantum at around 10-15% of total considerations
 Cash Interest of 4.0%-5.0% over EURIBOR
 PIK interest of 4.0-5.0%

High Yield
High Yield fulfils the same financing gap as Mezzanine, ranking ahead of equity but subordinated to Senior Debt.
High Yield however taps a different investor base and consequently the risk/reward balance is invariably more
skewed towards risk than that for Mezzanine Debt providers. The rules of thumb with regard to High Yield are:
• Bullet repayment and tenor of at least 10 years
• Covenants at 10% discount over senior
• Quantum at around 10-15% of total considerations
• Interest rate of 6.0%-8.0% over EURIBOR paid in fixed cash yield

Pay-in-kind and pay-if-you-can-notes

Paid-in-kind (PIK) or pay-if-you-can (PIYC) notes are characterised as deeply subordinated debt. These
instruments are repaid through bullet payments and usually have light business and financial covenants. General
rule of thumb for the amounts of these instruments is around 5.0-7.5% of total consideration. Interest margins are
generally 300-400 bps above mezzanine/high yield.
Valuation Manual

Figure 16: PIK and PIYC note payment structure

PIK note PIYC note

Outstanding

Outstanding
Time Time

6.3.2 Equity

Institutional Equity
In looking to allocate equity between institutions, the management and, sometimes the vendor, the starting point is
to satisfy the institutional investor. Areas that need to be considered are:
Total Return
The return investors require will be heavily influenced by the perceived risk of the investment; however in general
financial sponsors will look for IRRs of c. 20-25% (or lower for infrastructure assets: often 10-15% or even lower
for core infrastructure funds investing in toll roads/PPP projects etc).
Current yield
Institutions may require some sort of current yield within a reasonable time frame of the investment being made.
Whether or not an institution requires a current yield often depends on how the institution is financed.
Different equity forms
One of the final considerations is what sort of instrument is offered. The three main categories are:
• Ordinary shares
• Preference shares
• Loan notes
Loan notes have the advantage of tax deductibility on interest although this can give the perception of high
gearing. There are however restrictions on the amount of loan notes that can be put into any financing structure
without compromising tax deductibility on the interest due to Thin Capitalisation rules.
The other main reason for not using simply ordinary shares is that a ‘geared’ equity structure can help to
incentivise management.

Vendor Equity
This type of equity has some principal benefits:
• The vendor can increase the headline price. The fact that he may not receive a portion of the value of the
company for a few years may not matter to him
• Often helps the deal get done
• Can give vendor a veto over the exit route
• Insurance – the vendor may be a distressed seller and a retained interest allows him to share in any upside
• Straight vendor equity participation is much harder to manipulate than performance related deferred
consideration – vendors share pound for pound with other equity investors on exit

Other characteristics of a vendor loan are:

• Ranks behind subordinated debt and can be classified as quasi-equity
• Generally unsecured
• Relatively low interest costs commonly PIK
• Interest costs often not tax deductible
Valuation Manual

Obviously vendor participation can be structured to meet particular needs such as current yield through the use of
appropriate instruments.

Management Equity
The amount of management equity will vary depending on the size and structure of the transaction – typically 5%-
15% of ordinary equity:
• The management should put in enough to make them feel at risk and work hard but not so much that they are
weighed down with a huge burden. A reasonable rule of thumb is 1-2 times their salary
• The proportional entry price paid by management should not generally be less than a third of that paid by
institutions. This is sometimes referred to as the envy ratio
• Returns on exit should give the management in the region of 10 times their investment assuming the cash flow
forecast is met
• In secondary buyouts the typical rollover of management is at least 50%

Other elements include:

• Restrictions on transfer of shares (e.g. good leaver/bad leaver clauses)
• Provisions are made for future joiners
• Part of shares in foundation that issues certificates/options for employees
• Special class shares (“sweet equity”) given to management/employees

Envy ratio
Envy (also ratchet mechanism) is the ratio between the effective price paid by management and that paid by the
financial holder for their stakes in the NewCo. It refers to the inequality in investment between the financial buyer
and management (in favour of management).
[IC / I%]
Envy =
[MC / M%]
where,
MC = management investment in NewCo
M% = management % of ordinaries in NewCo
IC = financial buyer investment in NewCo
I% = financial buyer % of ordinaries in NewCo
High envy between management and financial buyer means that management can participate relatively cheap and
therefore is indicative for IRR difference between management and financial buyer. However, high envy does not
automatically mean higher IRR as financial buyer can increase return on equity layers management does not
participate in hence diluting IRR management.

Sweet equity
Financial buyers often allow for sweet equity participation (special class shares, or option structures) that are
triggered when certain internal rate of return thresholds are realised upon exit.
An example of sweet equity participation could be
• X ≤ 12.5% +0% of the exit proceeds for ordinaries
• 12.5% < X ≤ 15.0% +1% of the exit proceeds for ordinaries
• 15.0% < X ≤ 20.0% +2% of the exit proceeds for ordinaries
• 20.0% < X ≤ 25.0% +4% of the exit proceeds for ordinaries
• X > 25.0% +6% of the exit proceeds for ordinaries
where X is the IRR realised on the total initial equity investment
Valuation Manual

6.4 Entry and exit multiples

Entry multiples should always be calculated excluding transaction costs, and typically are based on the last twelve
months performance (for example: Purchase price/ Normalised LTM EBITDA). Transaction costs are generally in
the range 3-5% depending on deal size. Please keep in mind transaction costs related to debt financing (primarily
arrangement fees) are tax deductible.
An integral part of evaluating the returns achievable by the different providers of capital, is estimating the likely
value of the business upon exit (e.g. disposal/IPO) – a successful LBO typically will have a 5 year timeframe
(although one should model circa 10 years out) although this will depend on the nature of the business and the
extent of any restructuring which might be required.
The value of the company upon exit should be estimated using a sales, EBITDA or EBITA multiple. It is difficult to
ascertain what multiple would be attached to a particular sector several years hence. Any such multiples should
take into account various parameters:
 Entry price – it is unlikely that an LBO house will expect to sell the business for a higher multiple than it paid
for it. If buying with the expectation of high growth, a high multiple might be paid; in a few years time once the
growth potential has declined, the multiple will probably be reduced
 Multiples change over the business cycle
 Any premium to the entry price would have to be clearly justified
For modelling purposes one should never link the exit multiple to the entry multiple in your spreadsheet.
The exit multiple is highly dependent on the chosen exit route (for example IPO, highly leveraged IPO, trade sale
or secondary buyout), growth potential of the business at the exit date and the cycle. One can use rolling multiples
to determine cyclical movements of the multiples over time and subsequently at the expected exit. In addition one
could determine the exit value with a DCF approach; discounting the expected free cash flows from the exit date
onwards with the appropriate WACC. Please note the WACC will be depended on the chosen exit route and may
be difficult to determine.

6.5 Returns to capital providers

Having established the enterprise value of the business upon exit, one can estimate the returns attributable to
each form of capital. After deducting the remaining net debt (senior debt, mezzanine and cash) and other cash
outs and value adjustments relevant at exit (e.g., transaction costs, prepayment penalties etc.), the amount
available will be distributed to the shareholders.

Internal Rate of Return (IRR)

The IRR can be calculated with the following formula:
∞
 E(CFt ) 
I0 = ∑  t 
t =1  (1 + IRR) 

where,
I0 = initial investment of the financial buyer (sources)
E(CFt) = all expected cash flows to and from the financial buyer

Expected cash flows include i) intermediate dividends received (e.g. from recaps or cash dividends), ii) additional
investments in Newco (e.g. for add on acquisitions), iii) proceeds upon exit. In order to calculate IRRs in Excel one
should use the XIRR function, in order to cope with a flexible time frame between cash flows.
Valuation Manual

Figure 17: IRR functionalities in Excel: IRR vs XIRR

IRR function in excel assumes a time frame of 1 year between the cash flows XIRR function in excel makes the time frame between cash flows flexible
RECAP end of 2006 RECAP half of 2006

IRR equity providers start 2005 end 2005 end 2006 end 2007 IRR equity providers start 2005 end 2005 half 2006 end 2007

Initial equity investment -100

Dividend from recap 0 0 30 0
Equity proceeds from exit 0 0 0 125 Date 01/01/2005 31/12/2005 30/06/2006 31/12/2007
Total equity cash flows -100 0 30 125

IRR 17.0% Initial equity investment -100

Dividend from recap 0 0 30 0
IRR(C6:F6) Equity proceeds from exit 0 0 0 125
Total equity cash flows -100 0 30 125

IRR 17.8%

XIRR(C29:F29,C23:F23)

IRRs vary depending on the time of disposal (exit). Sensitivity analysis can also be conducted on, inter alia, the
transaction price (the entry multiple), the level of debt provided and the exit multiple anticipated.

Money Multiple (MM)

In addition to IRRs financial investors often look at the money multiple as indication of return on their investment.
Money multiple reflects the ratio between the total proceeds that accrue to the equity investors and their initial
investment. It is a measure for the absolute return made on the initial investment.
MM = [Intermediate cash flows + exit proceeds] / initial investment
One generally uses money multiple as return indicator as i) the IRR is biased to short holding periods rather than
absolute return and ii) management/employees are more interested in absolute return and often don’t fully
understand IRR.

6.6 Check list for an LBO analysis

When modelling an LBO the following check list could help you in developing this.

Business forecast
 Is business forecast not too optimistic (seller) or pessimistic (management) but credible?
 Are operating improvements and value enhancements (growth, margin, capex and NWC) accounted for in
forecast?
 Is business forecast supported by experienced/committed management team and are they able to achieve it
Debt structure
 Is debt maximised given typical LBO structures?
 Are margins and redemption schemes optimised?
 Are financial debt covenants satisfied with some headroom?
 Are debt levels in line with business risk and quality of asset base?
 Are tax (thin capitalisation) and legal (maximum upstream guarantees by operating companies) restrictions
accounted for?
Equity structure
 Are incentives of financial buyers and management well balanced and aligned (in terms of envy ratio and pain
level)
 Is leverage across equity layers optimal?
 Are there unused tax shields to be captured with creative structures (SHLs)?
Exit route and value
 Is exit multiple realistic (fundamentals) and does it differ from entry multiple? And why?
 Is exit EBITDA level well calculated (LTM, normalised, consistency in accounting standard)?
 Are proceeds upon exit well calculated (e.g. option exercise, sweet equity, transaction costs, mid year)?
 Do we have a clear exit route?
 Is exit date realistic and optimal?
Valuation Manual

 Is IRR calculation correct (e.g. no intermediate cash flows forgotten)?

IRR and MM
 Are all strategies to enhance expected IRR fully analysed (e.g. recaps)?
 Is IRR target of the private equity player realistic given risk profile of the business and the level of leverage
(risk adjusted IRR)?
 Did we also have a look at the MM and does it lead to other conclusions than IRR?
Valuation Manual

Appendices
Valuation Manual

I. Modelling tips & tricks

1. If preferred, use different worksheets in Excel to divide up the constituent parts of the model for easy access
and reference (e.g., separate tab for historical data, forecast assumptions, financial statements, ratio analysis
and valuation). On different sheets use the same column for the same year
2. Use colours for different types of cell inputs for example blue for hard historical data, red for
assumption/forecast cells, green for links from other tabs, purple for comments and black for formula.
Include a legend in the model explaining the different colours
3. Use the comment functionality in Excel to explain certain assumptions, data sources or calculations. Always
indicate the units in use
4. Always do calculations in the model and never calculate the same thing at two different places. Do not do
calculations separately on a calculator and input them hardcoded in the model as this can be confusing for
other users (including yourself). In addition never put hardcoded calculations in one cell but clearly define the
hard coded inputs and calculations in separate cells
5. For models with different business units on separate sheets of the model, first think about the structure of the
model and make sure that the business units are easy to consolidate (e.g., key financials such as BU
revenues, BU EBITDA etc. on the same row of each worksheet of individual BUs)
6. Try to avoid formula linked to cells on different worksheets of the spreadsheet model. Link the relevant cells of
the formula first to the worksheet where you are making the formula in order to improve traceability of the
formula
7. When picking up the same data in different worksheets, try to link the cells as much as possible from the
original source/calculation. Naming cells or cell ranges could be useful in this
8. From start, make sure that the different worksheets are consistently formatted and can be easily printed out.
Pay attention to print size, font type and size, headers/ footers and rows/columns to be repeated at top/left
9. If more than one cell changes with the same number X, it is recommended to create a separate input cell for X
so it is easy to sensitise all related cells
10. Because Control [ enables you to move directly to the first cell in a formula, built the formula first with cells
from the other worksheet and than to existing worksheet. For example 'drivers'C1+D5 instead of
D5+'drivers'C1. However try to avoid links to different worksheets in the spreadsheet model
11. Avoid linking different spreadsheet files
12. Build in error traps e.g. balancing balance sheet with conditional formatting
13. Use back of the envelope checks and common sense checks to challenge your detailed model
14. Use graphics to quickly identify trends that suggest errors
15. Save the spreadsheet regularly under different versions
16. Always let a third party check your model
17. Include time and date on sheets

But most important of all; keep your model simple and structured (so other people can easily understand
and use it) and focused on the problem you want to solve!